Market Overview

Tickers

Articles

Keywords

Jeremy Grantham v Bob Doll - Can Record Profit Margins be Maintained?

Anyone observing the financial blogosphere the past few years will surely have read that corporate profit margins have exploded as global labor and tax haven arbitrage have been exploited by the multinational class. Within the U.S. the share of profits between capital and labor have swung to extreme levels historically in favor of capital. Labor has paid the price. The question is.... is this a new normal, or is this simply unsustainable. Investment guru Jeremy Grantham leans to simply unsustainable (which he outlined in his August letterDanger Children at Play) whereas Blackrock's Bob Doll says this is the new normal. I am afraid I have to side with Doll on this one, if I am going to be consistent with my long held theory that the global labor class is going to fall towards a median across borders. When pressured with rising wages (or taxes) in one country, the multinationals march to the next colony country. Therefore the American, or western European worker demanding a return to the 'good ole days' will be smirked at. I hope I am incorrect on this one, but thus far - not so much. Also don't forget the role of automation - you want health benefits? Forget it, we're going to get some robots....

Wildcard? Some sort of global energy shock where 'producing local' is a requirement.

U.S. companies are the most profitable in more than 40 years, and some of the best-known stock pickers are divided over how long that will last. Bob Doll, chief equity strategist at BlackRock Inc. (BLK), said low labor costs and cost-saving technology will allow companies to keep up their profitability. Jeremy Grantham, chief investment strategist of Boston-based Grantham, Mayo, Van Otterloo & Co., said margins will send stock markets tumbling when they eventually revert to their mean.

“The implication for the stock market is ugly, because it means earnings are unsustainably high,” Grantham's colleague Ben Inker, GMO's director of asset allocation, said in a telephone interview. GMO, an investment manager that oversees $93 billion, puts the fair value of the Standard & Poor's 500 Index at between 950 and 1,000, compared with the 1,158.67 level at which it closed last week.

U.S. companies' ability to squeeze more profit from each dollar of sales is pushing earnings higher, even as the economy has grown at a below-average clip since the recession ended in June 2009. Grantham, who called corporate profits “freakishly high” in an August commentary, sees wide margins as an aberration.

Grantham also believes in mean reversion, the notion that most measures drop back to their historical norms over time. “Lower margins are the great threat to market performance,” he wrote in the August newsletter. Grantham is known for his bearish investment outlook and for his successful record in identifying stock-market bubbles.

Margins have been propped up by a “great surge” in government spending that fueled consumption, Grantham said. As political pressures force the U.S. to cut its budget deficit, the economy will suffer and margins will drop, Grantham predicted without laying out a timetable. (this is true - the government has stepped in with its 10% annual deficit spending the past 3 years to prop up customers, letting the government bubble replace the housing bubble as a driver of incomes. If government ever became serious about cutting the deficit it would be a threat to the current system - but since our political body can't help themselves, there will not be any serious cuts. After all "no one wants to raise taxes in this environment" in 1 party combined with everyone is a Keynesian in the other party leads to no serious changes ex accounting gimmicks. Hence Grantham has his behind covered by saying there is no timetable.) [Jun 6, 2009: 1 in 6 Dollars of Income Now Via Government, Highest Since 1929]

Grantham said of profit margins, “They do not seem to be connected to economic realty.”

Some of his competitors say changes in the economy and the way firms operate could keep them near peak levels for another year or two. “We don't think they have to fall,” Doll, whose New York- based firm is the world's largest asset manager, said in a phone interview. BlackRock oversees $3.35 trillion.

Two forces that have lifted margins, a weak job market and investment in labor-saving technology, show no sign of reversing, Doll said. “We lean towards the optimistic side,” he wrote in a Nov. 21 note on the stock market's prospects.

The margins of non-financial companies in the U.S., a widely used measure of profitability, reached 15 percent in the third quarter, according to data from Moody's Analytics . That was the highest level since 1969. When the recession ended in the second quarter of 2009, the comparable number was 8.7 percent.

Those on both sides of the debate agree on two things: margins are unusually high and the driving force behind their rise is companies' ability to keep a lid on expenses.

“Businesses have done a marvelous job of reducing costs,” Zandi said in a telephone interview.

The globalization of the workforce and a U.S. jobless rate of 9 percent last month have given management the upper hand in dealing with labor, Zandi said. (hmmm, sounds like something written on these pages 4 years ago) Wages and salaries as a share of national income fell to 49.4 percent in the third quarter, the lowest since the government began collecting the numbers in 1948, Moody's data show.

Companies, while slow to hire, have been upgrading technology. Businesses invested in equipment and software at an annual pace of $1.15 trillion in the third quarter, up 26 percent since the fourth quarter of 2009, data from IHS Global Insight in Lexington, Massachusetts, show.

Dennis Bryan is skeptical that the trends that have supported margins can continue.Bryan is co-portfolio manager of the $1.2 billion FPA Capital Fund (FPPTX). Firms may be reaching their limit in wringing out costs, after two years of rising margins. “Will companies be able to keep tightening their belts by cutting millions more Americans out of the workforce?” he said. (uhhh yes Dennis)

Profit margins have been trending higher since the mid-1980s, (and what trend started in earnest in the 1980s?) said Chris Christopher (awesome name by the way), an economist at IHS (IHS) Global Insight, who has written on the subject. Quarterly margins peaked at 11.9 percent in the 1980s, 13.6 percent in the 1990s and 14.5 percent in the most recent decade.

High margins are here to stay, said Allen Sinai, chief economist at Decision Economics Inc Cloud computing, which provides access to software and computing tasks remotely over the Internet, rather than through a company's own system, is just the latest tool corporations can use to keep costs in check, Sinai said. “This is the way of the world now,” he said in a telephone interview. “CEOs are paid to maximize profits.”